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On 19 November 2013, US Senate Finance Committee Chairman Max Baucus (D-MT) released a tax reform discussion draft on international tax issues that would require US-based companies to pay a minimum level of tax on foreign subsidiaries’ earnings.

The draft does not specify a targeted corporate income tax rate, though Chairman Baucus has previously indicated he is aiming for a rate lower than 30%. The staff summary states: “While the Chairman believes tax reform as a whole should raise significant revenue for deficit reduction, the package of reforms in this staff discussion draft is intended to be revenue-neutral in the long-term … These reforms are also intended to be coupled with a significant reduction in the corporate tax rate that is financed by broadening the corporate tax base in a manner that is revenue neutral in the long-term.”

The package includes statutory language, a Joint Committee on Taxation (JCT) technical explanation, staff summaries, and a request for comments on specific issues raised in the staff discussion draft, all of which are attached to this Alert. The release was described as a staff draft to solicit comments as the process moves forward, with the hope that Republican members of the Committee may sign on at a later date. A press release said the proposal is not a final plan, but rather is intended to spur a conversation about areas of common ground between the parties. Public comments are invited on the draft and requested by 17 January 2014.

The international draft is the first of three tax reform discussion drafts rolled out on consecutive days this week. A discussion draft on tax simplification and administration was released on 20 November, and another on cost recovery and accounting on 21 November.

Deemed repatriation, minimum tax

As part of a move to a new system that the Committee staff said would end the lock-out effect that results in US multinationals keeping foreign profits offshore, a deemed repatriation would subject historical untaxed earnings of foreign subsidiaries to a one-time tax at a reduced rate, subject to foreign tax credits (FTCs) and payable over eight years, with 20% provided as an example of what the rate might be. By comparison, House Ways and Means Committee Chairman Dave Camp’s (R-MI) October 2011 international tax proposal would subject untaxed, pre-effective date foreign earnings to US tax at a 5.25% tax rate, subject to reduction by FTCs and an eight-year payment option.

Under the Baucus discussion draft, passive and highly mobile income of foreign subsidiaries would be taxed at full US rates, as would income from sales of goods and services to US customers. Regarding foreign subsidiaries’ income from sales of goods and services in foreign markets, the draft puts forward two minimum-tax options:

• Option Y: A minimum tax of, e.g., 80% of the US corporate tax rate, subject to foreign tax credits. No further US tax would apply to foreign earnings upon repatriation.

• Option Z: A minimum tax of, e.g., 60% of the US corporate tax rate for income derived from active foreign business operations, and 100% for non-active income, again subject to foreign tax credits. No further US tax would apply upon repatriation.

Option Y

Under Option Y, a 100% dividends-received deduction would be provided for the foreign-source portion of dividends received from controlled foreign corporations (CFCs) owned for at least one year. A new category of subpart F income would be added for United States related income, defined as a CFC’s imported property income and United States services income. Another new type of subpart F income would be a CFC’s “low-taxed income,” encompassing active foreign income taxed abroad at or below a specified percentage, e.g., 80%, of the top US corporate rate (which is currently 35% and anticipated to be reduced as part of a tax reform measure). The financial services industry active financing exception would be revised and made permanent but would not exclude qualifying income from the low-taxed income category. The definition of a CFC’s insurance income would also be revised. These new subpart F income categories would replace the current foreign base company sales, services, and oil-related income rules, as well as the current rule regarding a CFC’s investments in US property. The current definitions of passive income would generally be retained.

The foreign tax credit limitation would apply separately to four categories of subpart F income (passive income, United States related income, insurance income, and low-taxed income) and two categories of other foreign-source income (foreign branch income, and all other foreign-source income).

According to the staff summary, interest deductions would be denied for interest expense attributable to tax-exempt earnings of foreign subsidiaries, if the domestic taxpayer is over-leveraged in comparison with the foreign subsidiaries.

Option Z

Under Option Z, subpart F income would be redefined as the sum of modified active income, which is a percentage, e.g., 60%, of a CFC’s active foreign market income; and modified non-active income, or the remaining income of a CFC after excluding active foreign market income. Income would be considered active foreign market income if attributable to economically significant activities of a qualified trade or business outside the US for non-US customers. Excluded from active foreign market income is any income if it is reasonable to assume that the property would be used, consumed or disposed of in the US or incorporated into another item that would. Passive income — dividends, interest, rents, royalties, annuities, etc. — would be excluded from active foreign market income.

Under this option, interest expense deductions would be denied for interest attributable to the 40% (for example) of modified active income not included in subpart F income.

For the purposes of both Option Y and Option Z, the check-the-box rules would be amended to prevent the creation of disregarded foreign entities owned wholly or partly by a CFC.

Also, the CFC look-through rule of Section 954(c)(6) would be abolished under both options.

The Committee requests comments on the merits of Option Y versus Option Z.

Base Erosion

Both options borrow from President Obama’s budget proposals to include workforce-in-place, goodwill and going-concern value in the definition of intangible property; and deny US insurance companies a deduction for nontaxed reinsurance premiums paid (i.e., any reinsurance premium paid directly or indirectly to an affiliated corporation regarding certain contracts, to the extent the income attributable to the premium is not subject to Federal income tax). Another provision would deny a deduction for any related-party payment arising in connection with a base-erosion arrangement, which is defined as a transaction reducing the amount of foreign income tax paid or accrued involving a hybrid transaction or instrument; a hybrid entity; an exemption arrangement; or a conduit financing arrangement.

The Finance Committee staff summary said that Chairman Baucus’s staff is considering Chairman Camp’s Option C “as a potential alternative framework for international tax reform” and requested comments on the merits of the proposal. Camp’s Option C would treat all of a CFC’s foreign intangibles income as subpart F income, but provide a 40% deduction on the US return, resulting in a 15% US tax rate (assuming a top corporate rate of 25%). The same 15% rate would apply to foreign intangibles income of a domestic company.

The summary also said that staff is considering additional ways to address base erosion by foreign multinational companies beyond the proposals in the discussion draft, perhaps to address the exploitation of treaty benefits. Staff requested public comments on “appropriate rules to limit such opportunities,” perhaps involving disallowing deductions for payments to related foreign companies if the payment is taxed at a low rate in the foreign jurisdiction, or potential new rules subjecting income to US tax if it is generated by customer-based intangibles related to sales in the United States by foreign multinationals.

Baucus’s staff also said it is considering a transition rule to allow US multinationals to bring intangible property held by their foreign subsidiaries back to the United States on a tax-neutral basis.

Other proposed changes

Among other provisions in the proposal, the Baucus draft would repeal the special rule for domestic international sales corporations (DISCs), the dual-consolidated loss rules and the title-passage rule for sourcing income from sales of inventory property. In addition, it would overhaul the rules applicable to passive foreign investment companies (PFICs) and make relatively minor changes to the rules regarding foreign investment in real property (FIRPTA) and US-source portfolio interest.

Other questions for public comment

Chairman Baucus’s staff also requested comments on:

• The treatment of foreign branches, and transition rules necessary if foreign branches are treated like foreign subsidiaries

• Transition rules for the Chairman’s proposals

• Potential tightening and expansion of “thin capitalization” rules

• The taxation of foreign subsidiaries doing business in the US territories

• International tax rules applicable to individuals, such as nonresident citizens of the United States

• The deduction for dividends received by domestic corporations and application of the dividends received deduction to certain sales and exchanges of stock and other elements of Option Y

• Repeal of foreign base company sales, services and oil related income rules and modification of foreign personal holding company income under Option Y

• Whether a form of CFC “look-through” rule should be retained and how such rule should interact with the low-taxed income rules

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